What is “Linking Three Financial Statements”

The three core statements to a fully integrated Three Statement Financial Model are Income Statement (I/S), Balance Sheet (B/S), and Cash Flow Statement (CF). As you build out your Financial Model in excel, you may create several schedules or tables that provide key data inputs into each of these three statements on an independent basis.  However, if you want to create a Financial Model that is highly flexible and enables a user to change assumptions and/or create different case scenarios, it is critical that the three core statements are integrated and the cells are “linked” in the Financial Model (excel version).

The fundamental integration between the three statements supports basic accounting principles:

  • Income Statement: An I/S derives Net Income for a Company which in turn explains the change in Retained Earnings for a Company (included in the B/S Equity calculations) and is linked to the start of the CF Statement to adjust the Company’s Net Income for the operating profit received in cash.
  • Balance Sheet: The revenue and expense forecasts in the I/S drive the current assets and current liabilities in the B/S. The Operating Working Capital calculation reflects these changes in current assets and current liabilities and this Net amount is linked to the Cash Flow from the operations section of the CF statement.
  • Cash Flow Statement: The ending Cash balance which sums the cash flow from the Operating, Investing, and Financing activities of the Company link to the Cash line item in the Current Assets of the B/S.
Key Learning Points
  • Linking the three key Financial Statements (Income Statement, Balance Sheet, Cash Flow) is critical to creating a dynamic and flexible Financial Model.
  • Net Income from the I/S links to the B/S (Retained Earnings calculation) and the CF (Operating cash flow calculation)
  • Changes in Current Assets and Liabilities from the B/S are aggregated to calculate Operating Working Capital which is linked to the CF statement.
  • The final step in building a Financial model is calculating Ending Cash Balance in the CF statement and linking it back to Cash in the Current Asset section of the B/S.

More Detail

Key Steps in Linking the Three Financial Statements. (Refer to Excel Template for illustration of specific Linking steps described below.)

  1. Forecast Income Statement
  2. Net Income feeds Equity on the Balance sheet and is linked to the cell where Net Income is added to calculate Retained Earnings. The Retained Earnings BASE calculation = Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
  3. Leave Interest Expense blank, as the Debt Schedule to the B/S, will calculate the Interest and link it to the I/S.
  4. Forecast Balance Sheet
  5. Leave Cash (under Current Assets) Revolver (S/T Debt) and/or L/T debt blank initially, as the Debt Schedule and CF will link back to the B/S.
  6. Build Net Debt and Interest Calculations. The Debt BASE calculation = Beginning Debt Balance + New Debt/Issuance – Principal Repayments = Ending Debit Balance. Depending on a Company’s Debt profile, the Debt Base Calculation will be repeated for each S/T and L/T Debt Facility and the Net Debt Ending Balances for S/T and L/T debt will be the aggregate of the Company’s Debt facilities and linked to the B/S. Any change to the principal amount of L/T Debt, such as New Issuance, or Principal Repayment is linked to the Financing section of the CF statement.  Interest calculation is calculated for each S/T and L/T debt facility and Net Interest Expense is the total for all of the combined Debt facilities and linked to the Income Statement. The Ending Balance
  7. Build the Cash Flow Statement
  8. Once the CF statement is completed, the cash from Operations, Investing and Financing are added to the Beginning Cash Balance (or Prior Year Cash Balance) and the Ending Cash Balance is linked to the Cash B/S.

Example

The attached excel worksheet shows an example of a simple, fully integrated three statement financial model.  (The links between the statements are color-coded for ease of reference.)

Conclusion

A fully integrated Three Statement Financial Model starts with building a Company’s I/S, then completing the various schedules for B/S line items specific to the Company, completing the CF statement by adjusting Net Income and accounting for the changes in the B/S, and lastly, determining Ending Cash Balance to link back to the B/S.  Once a Three Statement Financial Model is fully integrated, a user can run various case scenarios by adjusting one or more assumptions. A fully integrated The Statement Financial Model also serves as the foundation to analyze the financial impact of an M&A transaction/merger or an LBO scenario.

Topics Related to Linking Three Financial Statements include Balancing a Three Statement Model, Checking a Three Statement Model, Debt Schedule, and How to Avoid a Circular Reference.